Friday, September 26, 2008

China milk - tainted milk scandal

I read an interesting company update by DMG and partners regarding China milk. While I can't reproduce the entire report by cutting and pasting, I'll summarise the pertinent points here.

What happened

The whole story begins when recently, it was detected that the milk made in China have traces of melamine. A lot of babies in China, after taking in contaminated milk, had fallen ill and some had even died because of the toxicity. While most cases are contained in China itself, there are reports of one baby who suffered in HK. Despite this, a lot of countries had decided to ban china products outright for fear of further contamination. In Singapore, several products had been taken off the shelves too.

What is melamine

Melamine is a compound that is used in making plastics or fertilizers. It is a non-protein nitrogen containing compound, with about 66% nitrogen by mass and is known by it chemical name as 1,3,5-Triazine-2,4,6-triamine. Due to its high nitrogen content and its cheap cost, it is added to milk by farmer and/or companies to boost the nitrogen content of the raw milk so as to pass the protein test, which is used as an indicator that the raw milk supplied is of high quality.

Melamine can cause bladder and reproductive damages, specifically in the formation of kidney stones. The lethal dose of melamine is more than 3 g per kg of body mass. As such, most if not all the affected victims are babies, as their body mass are much lower than adults and hence the ingested amount, over a prolonged period of time, causes the above mentioned effects.

Possible causes of the addition of melamine to milk

China milk's management mentioned that the main reason why Chinese dairy farmers and companies add melamine is because of the poorer quality of raw milk. As the rising cost of animal feed and fertilizers increases (also linked to the rising price of crude oil) in 2008, the cattles are not fed as well as they should. The consequence of this malnutrition is that the milk produced by these cattles are also of poor quality - that is, of lower nitrogen content. In order for farmers and dairy companies to attain higher profit and margins, they need to send the raw milk supplied for protein test to indicate that it is of superior quality. Hence, the addition of melamine will serve this purpose.

How China milk can benefit from this

Management mentioned that earnings will be expected to remain stable because the core business of the company is not in selling milk but in selling bull semen, despite the name of the company. They mentioned the price of each straw of semen (specifically the pedigree Canadian bull semen in which they have a monopoly on) - RMB 70 per straw - and typically two straws are needed to impregnate a cow.

Since Canadian bull semen will produce cows which yield the best quality and volume of raw milk, the management believes that this will be an effective step in rebuilding China's reputation in the milk industry worldwide. China milk will stand to benefit from this process of rebuilding China's reputation. It will take 3 years from conception before a calf can be milked, so the healing process will not be short.

Furthermore, China milk grows 75% of their own feed and produces their own fertilizers, so they have the ability to control quality at each step of their value chain. Since feeds takes about 50%++ of their operating cost, they will stand to gain from their independence off the rising feed/fertilizer price.


While china milk mentioned in a separate announcement that they are not involved in the scandal, and none of their customers are listed in the affected companies mentioned in mass media, the industry wide scandal affects each and every player in it. It will take years before confidence will be regained.

It is important to note how the demand for china milk will be affected. If less domestic milk is consumed, then farmers will be less inclined to have more cows to produce milk, and the subsequent drop in demands for cow embryos and sperms will also be reduced.

JP Morgan listed china milk under high cash high debts - meaning a possibility of management's poor financial discipline.

How to benefit from this

PE of China milk is around 3x. I think one needs to do a projection of the earnings at much lower percentage than one based upon historical rates. Even if using a earnings growth of 5%, we have a PEG of 0.6. My views is that not much can go wrong, though I said it with a biased views of an investor with vested interest in it.

Addition announcement dated 26th Sept 2008

China milk posted another announcement on SGX. Here's a summary of the new announcement:

a. Management believes that the sales of raw milk are not expected to be materially affected as there is still demand from milk processor and milk product manufacturer

b. As the Group believes in the quality of its raw milk (which contain no additives) and because the shortage of good quality dairy cows in China still persists, the Group is cautiously optimistic that it will be able to continue securing orders to supply raw milk to its current customers (none of which are manufacturers of the affected milk powder brands in China).

c. In addition, the Group believes that there will not be any material adverse effect (financial or otherwise) on its other business relating to the sales of bull semen and cow embryos. Although the Group expects that there may eventually be some consolidation and/or adjustments in the milk production industry in China, the Group believes that there is still sufficient underlying consumer demand for dairy products in China. On the other hand, demand for its bull semen and cow embryos (both for breeding of dairy cattle as well as for fertilisation of dairy cows for the purposes of raw milk production) is expected to remain relatively consistent given the shortage of good quality dairy cows in China as a whole and the fact that dairy cows need to be fertilised every year in order to produce milk.

(I've seriously not thought about that before. I've always thought that the main economic moat of China milk is that it holds a substantial herd of Canadian Holstein, known for its high quality and high volume milk production, before China banned the import due to outbreak of mad cow disease. Now that they said it, it does make sense that the continued demand for sperm is due to the fact that diary farmers need to fertilize their cows every year to produce milk!)

d. The Group further believes that the demand for its bull semen and cow embryos will remain good as the Group only produces bull semen and cow embryos of Canadian pedigree.

e. Purely as a precautionary measure, the Group has sent samples of its raw milk to an independent laboratory for the relevant testing and will follow up with an announcement on the results of the tests after receipt of the same.

(I should wait for their report of the lab test. I like China milk's way of handling the crisis. How a company manages a crisis and offer words of confidence is as important as how they capitalise on the opportunity posed by the crisis.)


Sgbluechip said...

Hi LP, do you have the breakdown of the geographical countries in which China Milk revenue is derived?

I personally think that China citizens are unlikely to import milk products due to cost concerns (even if the govt allows) and if China Milk has a high concentration of its business markets in China, this crisis will be an excellent opportunity for them as their high quality semen/ milk (26% of revenue) will be highly demanded, in response with the low quality milk found in the market.

In fact, they can priced it even higher to justify its premim quality.

However, if they have say 40% of revenue from overseas market, their "China" brand may affect their sales.

What do you think is a good price to buy for this stock?



H said...

Hi LP,

Thanks for the write up!

"The table above shows some of the s-shares with warning signs. It's taken from a report from JP morgan. ..... I was a little perturbed when China milk had the privilege of being listed as the company with high cash, high debt. This 'indicates poor financial discipline', according to the report. 'Balance sheet management around book closure date, or in the worst case scenario, a possibility of fraud or embezzlement of cash' might be the possible reasons.

Well, it seems like chinamilk had the dubious honour of having total debt/market cap>30% and total cash/market cap>30%, hence it was identifed as having high cash, high debt."

LP, perhaps you can write an email to Chinamilk mgt and see how they response to this?

(although from my experience, they rarely response).

We can also see their investor relations.


la papillion said...


There are no geographical breakdown of their revenue. It is stated, however, that their revenue is mainly derived in PRC. In fact, their major customers of bull semen and cow embryos include various govt. entities in the PRC, while raw milk are mainly dairy product manufacturers in Heilongjiang in which they operate.

From what I understand, they do not export their semen, embryo or milk outside of PRC.

You raised a valid point about importing milk from other countries. I also doubt that the cost will prevent them from doing so. Rather, a more possible solution would be to source out higher quality, untainted sources of milk, locally in PRC. China milk also stands to gain from being on the 'producer' side of the chain. There really is a shortage of raw milk producers, though there are no shortage of milk product manufacturers.

Do temper my views knowing that I have vested interest in China milk.

Sad to say, I do not know what's a good buy in price for China milk! I didn't do a thorough job when I first bought this, so as such, trying to read up now :)

la papillion said...

Hi HH,

Hmm, good idea. I'll email them to see what response I'll get. I've a feeling they won't answer too, but let's give them a chance to impress me.

Touzi said...

Why was China Milk considered a high cash, high debt company? They have no bank borrowing, only covertible bonds at S$2 conversion price.

On the other hand, according to the annual report their short term bank deposit is 7 days to 3 months. Total interest earned for 2008 is RMB20,830,000. This is only about 1.1% of cash. Hmm...seems too low.

la papillion said...

Hi Touzi,

I think the report mentioned that china milk is high debts because of their total liabilities, which also includes their convertible bonds. It's true that they have low short term bank borrowings. I think they are worried that china milk's cash position could be faked. Otherwise, why don't china milk pay off their total liabilities using their huge cash/cash equivalents?

I've no ready answers too. I do know that the amt of cash sitting there, if they are not giving it off to shareholders as dividends nor re-investing back into their business, is not going to give a good returns and it will be shown on the ROE.